[Joseph_E._Stiglitz,_Carl_E._Walsh]_Economics(Bookos.org) (1)

but doing so leads to bigger swings in output and employment. Even though
they would like to keep the economy stable at full employment and low inflation,
policymakers must choose which goal to focus on—they cannot achieve both.
Policymakers do not face this same fundamental trade-off when the economy
experiences disturbances that shift the ADI curve, such as shifts in fiscal policy,
changes in spending decisions by households or firms, or economic fluctuations in
other countries that affect net exports. If the ADI curve shifts to the left, threatening
a recession, policymakers should engage in expansionary policies to offset the disturbance
and keep the economy at full employment. In doing so, they also keep
inflation stable. By offsetting disturbances that affect aggregate expenditures,
policymakers can succeed in stabilizing both employment and inflation. It is not necessary
to trade off one goal for another.
This is not to say that making policy decisions in response to demand disturbances
is easy. The problem of lags and the difficulties of forecasting still apply. An
example is provided by the Asian financial crisis of the late 1990s. It was widely predicted
that this would reduce U.S. net exports and slow the U.S. economy down. The
impact on U.S. output and inflation could be minimized if the Fed adopted a more
expansionary policy. But the Fed had to decide how much more. Should the nominal
interest rate be cut by 1 percent? 2 percent? And when? If fiscal policy should turn
more contractionary, the full-employment real rate of interest would fall, but by how
much? And how quickly would the fiscal contraction lead to a decline in spending?
In principle, the central bank can offset the impacts of shifts in aggregate demand,
such as fiscal policy, and keep both employment and inflation stable. In practice,
policymakers are not able to fine-tune the economy to this extent. The key lesson,
though, is that the choices between policy goals when supply shocks occur are much
tougher than those faced when demand shocks occur.
SHOULD THE FEDERAL RESERVE TARGET INFLATION? ∂ 859